If you saw $6,000 lying on the ground, would you pick it up? I certainly would. I think you would, too. But it's surprising how many investors routinely pass up this much free money by paying little attention to the tax implications of their investment selections. Here's an illustration of what I ...

Investors Are Selling Their Mutual Funds at Record Speed

Investors have been selling their mutual funds in record numbers. According to Morningstar Market Intelligence data, a net amount of $49 billion left mutual funds in September. That's the largest one-month outflow that we've seen since we began tracking redemption data in January 2000. Yet it looks like October is on pace to beat it. Looking at the first half of this month and only the portion of the mutual fund universe that has reported asset figures to us, we believe a more severe outflow picture is brewing for October. The heavy redemptions are likely due to the widespread losses that haven't been isolated to a few asset classes but have spread to more conservative asset classes and funds.

The heavy redemption activity that we've seen has implications for funds and shows a repeat of investor behavior that seems unlikely to pay off for anybody.

Lots of Redemptions and Little CashMany mutual funds are carrying a small amount of cash and, at the same time, facing large shareholder redemptions. The average domestic-equity fund held just less than 5% in cash as of its most recently disclosed portfolio. That means that they have little "dry powder" sitting around on the sidelines with which to buy depressed securities and meet redemptions.

Even if opportunities are plentiful (which many well-respected fund managers and industry pundits argue is the case), a fund facing redemptions is restricted in its flexibility to do much about it. If you're a mutual fund manager in this position, you have to sell more than you can buy, which is far from ideal when you're finding a lot more to buy than to sell. Different managers are dealing with this in different ways. Many have eliminated smaller holdings and concentrated more of the portfolio in their highest conviction picks. Others have been trying to hold more cash on hand in anticipation of redemptions.

Yet trading costs rack up with those forced transactions. Academic research on the topic by Roger M. Edelen, Richard B. Evans, and Gregory B. Kadlec has shown that fund trades motivated by shareholder cash flows are more costly than voluntary trades motivated by research. At its worst case, depending on the liquidity of holdings in the portfolio, redemptions can trigger a vicious cycle that can really drive down a fund's value.

We've seen that risk turn ugly during the past year with ultrashort bond funds such as Schwab YieldPlus and Fidelity Ultra Short Bond. The funds experienced some losses early on, which triggered redemptions that forced them to sell securities into an illiquid market, which locked in further losses, which invited more redemptions, so on and so forth. Such drastic illiquidity has been more of an issue with bonds (excluding Treasuries) than with stocks.

Beauty of Mutual Fund Structure Is Part of ProblemMutual funds are exposed to this risk because of the investor-friendly structure that makes them so appealing in the first place. They are an inexpensive, transparent, accessible, and well-regulated way for investors of all stripes to gain access to professional money managers and build diversified portfolios. In addition, most investors can sell their funds on a daily basis without incurring a cost, which further adds to their appeal--that is, until it gets out of hand.

When selling other types of investment securities, investors face some form of liquidity cost or consequence. The markets for stocks and bonds have a natural mechanism in place to deal with it; for every seller, there has to be a willing buyer at that price, or the sale can't happen at that price. Not so with mutual funds. Mutual fund owners have the right to sell back their shares on any day they please, and the fund has to buy them back at a price equal to the pro rata value of the underlying securities, or NAV. If those redemptions force the fund manager to sell securities at lower prices, the investor who redeemed doesn't bear the cost. Rather, it is spread across the entire pool of investors still in the fund. It doesn't really matter if you are the only shareholder trying to sell a fund at a good time or the hundred thousandth shareholder trying to sell at a bad time, you are both entitled to the same price: that day's closing NAV.